The Output Gap Debate

Or you could go with a simpler but more pessimistic explanation: both the level and growth rate of American potential output is much lower than we think. This would resolve all these puzzles: GDP growth of 2.5% is above, not at, trend, the output gap is closing, and it was probably smaller than we thought to begin with. That would explain why unemployment is falling so quickly, and why core inflation hasn’t fallen further. The excess supply of workers and products that ought to be holding back prices and wages is not as ample as we thought.

You can attack this problem various ways with Aggregate and Quasi-Aggregate analysis and I see a lot of economists and bloggers doing that.

I’d, however, encourage everyone, as well, to think of the disaggregated story that we are telling here. If trend GDP is overstated, then we are arguing that one or more sectors of the US economy will is less capable of producing output over the next decade or so, than we would have otherwise thought.

So then we might want to ask – what are those sectors?

Since, I don’t know exactly what folks will say I will offer this:

The majority of the output gap – over 5 percentage points of GDP – could be closed by a return to trend of the construction of housing, hospitals and medical facilities and public infrastructure as well as an increase to trend in the production of transportation equipment.

So one, direct hypothesis would be that these things cannot or will not return to trend.

I have spent a fair bit of time trying to argue that the total stock of housing is below trend and that housing would become extremely tight leading to rapidly rising rents. So far rents do appear to be rising and as of now – rising rents consitute the bulk of the inflationary gains.

If we are to ask why there is inflation in the face of slack, the simple answer is there is not. There are not enough houses in America and the price of housing is indeed rising.

If we are to ask why the market doesn’t correct, then the most obvious answer is collateral constraints. They may not be the right one, but it’s a story that seems consistent all up and down the line. Its even consistent with the observation that an ever increasing number of homes are bought with cash by investors who intend to rent them out and that some new multi-family housing projects are coming on line with 100% equity.

However, this is not something permanent. The price of houses – or more specifically land – will not continue to fall forever and indeed appears close to bottoming.

A similar phenomenon explains the slowdown in the purchase of transportation equipment which has been heavy and hard among low FICO buyers in states with rapidly falling housing prices, but has returned almost to trend among high FICO buyers in states with slowly falling housing prices.

Public infrastructure faces similar constraints. The decline from trend in hospitals and medical facilities is more of a mystery.

So, if we think these things will repair themselves then we have an obvious path back to trend.

I don’t want to get too invested in this but a cursory look at the data suggests that GDP is likely to grow above trend in the coming years because two very high productivity export sectors are expanding – computers and gasoline and distillates.

Call this the Apple and Exxon effect, but even without increased consumption by Americans, things which potentially return a lot of GDP per worker to America are growing.

Which brings me to make a quick note on one Felix Salmon’s points

In other words, in order to keep up a steady rate of GDP growth, we had to saddle ourselves with ever more cheap and dangerous debt.

Then, suddenly, the growth of the credit markets screeched to a halt, and we had a major recession. And since then, the size of the credit market has been roughly flat.

It makes sense that if we needed ever-increasing amounts of debt to keep up that long-term GDP growth rate, then when the growth of the debt market stops, our potential growth rate might fall significantly

This sounds compelling to a lot of folks but to me its not clear what the underlying story is.

In terms of household debt as a percentage of PI there were a series of run-ups but as you can see they are mostly about mortgages.

The run-up in the 80s was the Volker dis-inflation. Remember that when both interest rates and wages decline from dis-inflation, principle balances as a percentage of income rise mechanically for long term debt.

The second run-up was of course the housing bubble. A small portion of this went into the increased production of single-family houses, though at the expense of mutli-family and manufactured housing. However, most of it went into the price of land. Which meant that some of it was simply a wealth transfer between Americans.

Now, there are some people – some I know – who will never work again because they sold their house at the top and moved into a rental. That possibly reduces long-term GDP if the number of workers has fallen. However, this group of people is likely small and balanced out by those who will not get to retire when they hoped because they took on larger mortgages.

Some of the increase in debt funded a steady increase in net real imports over that period. However, this does not add to GDP and as it retracts we should not expect GDP to decline.

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The growth industry was land price appreciation employing no one and producing only higher prices, incomes, and debt. its fall lowered prices and incomes of everyone, owners and those selling to them alike. The debt was largely between America and the world during the run up and the world and the government now. Debt written off is a loss to the creditor, now the government, but no gain to the owner as the creditor now owns an asset worth less. We will grow from here, but the point is from here. We have no means we are willing to use to restore land prices to what they were, nor could they without inflating incomes to what could afford to pay those prices. We are all poorer than we thought.

*First, the inverse of the relationship is what is relevant (see below).

* Second, going back to the 1950s, there is a consistent increase, (or more pertinently, drop in GDP/Debt). there is no correlation to interest rates or money velocity, its not a “credit binge” thing.

So what could this possibly mean??

First, lets talk about the pile of bricks, total debt. {technically, you want to remove financial debt because the assets and liabilities of a bank are both debt so you’re double counting, but then the billions of dollars Apple has in cash is parked in short term “investments” which are also debt, but the difference does not matter}.

That pile of debt really is the pile of bricks, or capital we’ve built up over time.

GDP is nothing more than the flow of brick-making activity.

so what does the ratio mean??

Well, go back to a simple Tobin’s Q type formulation. the ratio of GDP/debt really is fundamentally the GDP/capital ratio more or less.

So all this graph really says is: 1) the marginal product of capital has been decreasing; and 2) we’ve built up an awful lot of capital (i dunno, maybe for all those baby boomers who are about to retire).

Now, if you think of the “debt” as capital and suppose you need a real rate of return of, say, 4% then 4%*totaldebt/gdp is about 15% of gdp or less. yawn, not really so unsustainable is it?

An for anyone who complains we owe “debt” to foreigners, the flip side is the productive capacity … as long as we can basically earn a income sufficient to pay the interest on the debt as a % of GDP then the zombie apolcalyspe is not imminent.

… incidentally, for those of you who complain i’ve left a bunch of stuff out of the demoninator for Tobin’s Q (market cap of equities, etc) sure you are correct. There may be some tax reasons to favor debt vs equity financing of capital.

now that would be an interesting economic debate.

… but for a bunch of economists to be confuddled by a bunch of journalists spouting economic nonsense, really sad. truly the dark ages.